Sunday, December 28, 2014

There were plenty of reports in the press this year accusing central banks of behaving like King John, stealing from the poor to help the rich. Rich people's wealth tends to be geared towards holdings of stocks and bonds whereas the poor are more dependent on job income. By pushing up the prices of financial assets, central bank quantitative easing helped rich people while leaving the poor in the dust.

There are a lot of problems with the King John critique of quantitative easing.

First, a good argument can be made that QE had almost no effect on prices. Insofar as purchases were considered temporary by market participants, then the newly created money would not have been spent on stocks and whatnot, its recipients preferring to keep these balances on hand in order to repay the central bank come the moment of QE-reversal. If so, the large rise in equity prices since 2009 is due entirely to changes in the fundamentals and animal spirits, not QE.

But let's say that QE was not irrelevant and can be held responsible for a large chunk of the rise in equity prices over the last few years. Even then, the real economy, and therefore the poor, would have been equal beneficiaries of QE. As I pointed out in my previous post, financial markets are not black holes. Newly-created money, insofar as there is an excess supply of the stuff, cannot stay 'stuck' in financial markets forever. For every buyer of a financial asset there is a seller, and that seller (or the next seller after) will choose to do something 'real' with the proceeds, like buying a consumption good, investing in real capital, or hiring an employee—the sorts of purchases that benefit the poor. So if QE succeeded in pushing up financial markets (thus helping the rich), then the real economy (and the poor) must have benefited just as much. The King John argument doesn't hold much water.

But wait a minute. If both financial markets and the real economy were equally inflated by QE, then why have wage increases been so tepid relative to equity prices? One explanation is that wages are sticky whereas financial prices are quick to adjust. The relative wealth of the poor, comprised primarily of the discounted flows of wage income, stagnates, at least until wages start to catch up at which point it is the turn of the the relative wealth of the rich to decline.

Can we right this short-term wrong? Even if we try to convert central banks from being King John central banks into Robin Hood ones, things wouldn't change. Say we change where central banks inject new money. Instead of conducting QE with a select group of banks, central banks now purchase directly from the populace. And instead of buying financial assets, they bid for stuff that regular folks own, like cars, houses, and wedding rings. The moment Robin Hood QE is announced, the same effect occurs as when King John QE is announced: the prices of financial prices will be the first to jump. This 'injustice' occurs even though the counterparties to Robin Hood QE are all too poor to play the stock market and the items being purchased from them are not financial assets. Consider that an impoverished recipient of new funds may use them to purchase something at a grocery store, and the owner of that store may in turn use the proceeds to buy new inventory, and the farmer producing that inventory could use the funds to buy seed, etc etc. Someone along this line will eventually purchase shares. However, stock markets participants don't wait for this excess money to flow into stock markets before marking up prices; they adjust their offers ahead of time upon the expectation of excess money being used to purchase stocks. Robin Hood QE or not, the relative wealth of the rich is the first to rise thanks to flexible financial prices, at least until sticky wages start to catch up. This isn't the fault of central bankers, and there's no way they can restructure their operations to promote short-term equality in wealth.

How long can this short-term inequality last? I can't see it lasting longer than a year. Maybe two. But we've seen so many years of QE now that I don't think we can attribute the gap between the rates of increase in stock prices and wages to stickiness. The most likely explanation is the one in my third paragraph: on the whole, QE has done very little to affect prices, whether they be financial or not. Wages have been stagnant because QE is irrelevant, or at least close to it, and the S&P 500's rise from around 700 to 2090 has been by-and-large achieved of its own accord. Without QE, where might the S&P be? Maybe 2060, or 2065?

Central banks aren't like King John, nor is there anyway we can turn them into Robin Hoods.

Friday, December 19, 2014

Marc Faber is a very knowledgeable guy, but thumbing through a copy of his most recent Gloom, Boom, & Doom Report, I stumbled on a pretty big error. Here is Faber:

"All the liquidity that central banks have created isn't flowing into the real economy but remains in asset markets (mostly financial markets) buying and selling currencies, bonds, stocks, real estate, art, entire companies, etc. For example, most corporations find it advantageous to buy back their own shares (in order to boost their share prices) instead of investing in new plant and equipment... Or take wealthy individuals as another example. Most of them invest in stocks, bonds, funds or real estate; very few of them go out and build businesses. Private equity funds do the same: instead of building new businesses, they tend to buy existing assets."

and later on:

"I believe that as long as savings and newly created fiat money flow into booming and speculative asset markets, real economic activity will remain depressed."

Faber is repeating a very old fallacy that goes something like this: new money and credit can stay tied up in financial markets indefinitely. This unproductive absorption of capital by speculators in turn prevents the real economy from benefiting. New buildings and factories go unbuilt, consumer goods go unsold, and cutting- edge technology goes undeveloped because the stock market 'sucks up' all the money.

Marc Faber styles himself as an Austrian economist, so he should know that Fritz Machlup, an Austrian 'fellow-traveller', dealt with this particular fallacy in his 1940 book The Stock Market, Credit and Capital Formation (pdf).

In a nutshell, newly-created money (or already existing money) that flows into stock and bond markets does not enter a financial black hole. For every buyer there is a seller. By definition, money will flow away from the market on which it is spent just as quickly as it enters it.

Here is the argument in more depth. Say that Frank (for lack of a better name) invests fresh money in a new issue of corporate shares. These funds don't fall into an abyss. Rather, the issuing company now owns them and uses them to build a factory. Faber would approve since machinery is being created from scratch.

But even if Frank uses the new money to buy already-issued shares rather than newly-issued shares, these funds don't get sucked into a vortex. They are now held by the seller of the used shares, Tom. And the moment Tom uses these funds to buy a car or invest in his home business, they are released into the real economy.

Of course, Tom might simply reinvest the funds earned on the sale in another stock or bond. But this changes nothing since an entirely new seller, Sally, comes into ownership of the funds. Like Tom, Sally might choose to invest it in real capital or on consumption, the real economy enjoying the benefits. Or she might choose to reinvest in the stock market, selling to Harry, and so on and so on. But even if the next ten or twenty recipients of Frank's newly-created money all choose to reinvest those funds in equities, the stock market is nothing akin to a black hole. At some point along the chain the money will inevitably arrive in the account of an investor who chooses to dispatch it to the so-called real economy by either purchasing consumption goods, services, or some sort of industrial good. Though the chain along which this money might travel can include many people along the way, when it finally exits only a few financial heartbeats will have passed.

So in sum, contra Faber money and credit cannot be held up inside speculative markets. It doesn't take long for it to be spent into the real economy.

For those who like to keep track of these things, the 'financial black hole' myth is related to the 'idle cash on the sidelines' myth, dealt with ably by John Hussman many years ago. In the 'sidelines' story, money sniffs its nose at the market and stays at the edge of the dance floor only to have a sudden change of heart, subsequently flooding the stock market. But as Hussman points out, when you put your cash on the sidelines to work in the stock market, it becomes someone else's cash on the sidelines. Both the black hole and sidelines stories are wrong because money doesn't disappear when it is spent. Rather, there is a seller who is left holding the stuff.

Friday, December 12, 2014

To understand short-selling, start with three words: “Borrow and sell.” The short-seller in figure 1 borrows a share of GM stock from a stockholder and then sells that share of stock to a buyer for $60 cash. If GM subsequently drops to $50, then the short-seller can buy a share of GM on the open market for $50, repay that share to the stock-lender, and profit $10. But if GM instead rises to $70, then the short-seller loses $10, since he must pay $70 to buy the stock before repaying it to the stock-lender.

As the short-seller borrows one share of GM, he hands his IOU to the stock-lender. This IOU promises to deliver a share of GM stock. (It would also promise to compensate the stock lender for any dividends missed as a result of lending the stock.) Since the IOU can be redeemed for a genuine share, the IOU will be worth the same as a genuine share. This means that the stock lender does not have much reason to care whether he holds the genuine stock or the IOU (unless he cares about losing his voting rights in the corporation).

Figure 2 shows a simpler way to sell short. The short-seller simply writes up an IOU and sells it directly to a buyer. This kind of short sale gives the same payoff as the “borrow and sell” short sale of figure 1. If GM falls to $50, the short-seller gets a $10 profit, while if GM rises to $70, the short-seller loses $10. This method of short selling is so simple that it can happen by accident. Suppose you're a stockbroker, and a client calls asking you to buy one share of GM for him. You answer, “OK, you got it”, and hang up, planning to deliver the actual stock later in the day. You have just gone short, and you stand to gain $1 for every dollar the stock falls, while losing $1 for every dollar it rises.

A still simpler way to go short is to make a bet with someone, as shown in figure 3. The terms of the bet are that for every dollar GM falls, the buyer pays the short seller $1, while for every dollar GM rises, the short seller pays the buyer $1. The payoffs from this bet are the same as the other two methods of short selling. The bet shown in figure 3 is like a futures trade: There is no actual delivery of GM stock, and gains and losses are settled periodically, including adjustments for dividends. In contrast, the trade in figure 2 is like a forward trade: There is a promise to deliver GM stock, and gains and losses accumulate until the position is closed out.

Some common misunderstandings about short selling:

1. Are these IOUs counterfeit shares? Do they dilute the underlying stock and reduce its value?

No, no, and no. And never mind what Overstock.com CEO Patrick Byrne says. The short seller who issues the IOU puts his name on that IOU, recognizes the IOU as his liability, and stands ready to deliver a genuine share to the holder of the IOU. These are not the actions of a counterfeiter. But suppose there are 1 million genuine shares of GM stock in existence, and that short sellers have collectively issued 2 million IOUs. In a sense, the quantity of GM shares has tripled, and you might expect the share price to fall to 1/3 of its former level. But don't forget that GM did not issue the IOUs, and they are not GM’s liability. They are the liabilities of the short sellers. The issuance of IOUs through short sales does not affect the number of genuine GM shares, nor does it affect GM’s assets, so it can't affect share price. If short selling somehow did put share price out of line with the firm's actual value, then arbitragers would pounce. There will occasionally be liquidity crises when markets break down, stocks are hard to borrow or hard to buy, and arbitrage can't play its usual role; but in normal conditions, arbitrage assures that short selling does not affect share prices. Besides, short selling itself helps to keep markets liquid, and makes these liquidity crises less likely to occur in the first place.

2. What is a naked short?

In figure 1, a naked short would occur if the short seller failed to deliver the genuine share to the buyer within 3 business days. If this happens, the “borrow and sell” short of figure 1 reverts to the “forward style” short of figure 2. The buyer ends up holding the short seller's IOU, rather than the genuine share. If the short seller fails to deliver the genuine share even after an extended period, then the two traders could still settle up with each other in cash or other securities. The “forward style” short of figure 2 would thus revert to the “futures style” short of figure 3. If worse comes to worst and the short seller defaults, then either the stock exchange will make good the loss, or the traders will get a costly lesson in placing too much trust in their fellow man. Sometimes the SEC will step in, and traders will get an even costlier lesson in placing too much trust in the government.

Note that in all three methods of short selling, the dollar payoffs to both traders are identical. This highlights the futility of the numerous restrictions that governments place on short selling in general, and on naked short selling in particular. In the first place, any legal restriction on one type of short selling will only cause traders to switch to a different kind that is not so easily restricted. In the second place, studies show that when governments do succeed in suppressing short sales, markets become less efficient.

3. Short selling and money

When you buy a house, you borrow dollars and then sell those dollars for a house. This makes you short in dollars, just like borrowing and selling GM makes you short in GM (figure 1). Alternatively, you might buy that house by handing your IOU directly to the house seller. This would put you in a “forward style” short position in dollars (figure 2). If you are well known and trusted, then your IOU can actually circulate as money. But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU. The bank's IOU will circulate more easily than your IOU, so we commonly talk as if the bank has created money. This is not quite right because the bank is not short in dollars on net. The bank went short in dollars as it issued its IOU, but it took an offsetting long position in dollars when it accepted your IOU. The bank is therefore neutral in dollars, while the borrower is short in dollars. This is why it makes sense to say that borrowers are the original issuers of money, while the banks only help out by putting their name on the money.

It's reasonable to think that short selling of money is governed by the same principles that govern short selling of stocks. Specifically, the fact that short selling of stocks does not affect stock price makes us expect that short selling of money will not affect the value of money. I think this view is correct, but it puts me at odds with every economics textbook I have ever seen. The textbook view is that as borrowers (and their banks) create new money, they reduce the demand for base money, and this causes inflation. This is where things get weird, because the borrowers, being short in dollars, would gain from the very inflation that they caused! Nobody thinks this happens with GM stock, but just about everyone thinks that it happens with money.

If the textbooks are right, then the value of the dollar is determined by money supply and money demand, and not by the amount of backing the Fed holds against the dollars it has issued. For example, if the Fed has issued $100 of paper currency, and its assets are worth 30 ounces of silver, then the backing value of each paper dollar is 0.30 oz/$. But if the money supply and money demand curves intersect at a value of 1 oz/$, then the dollar will supposedly trade at a premium of 0.70 oz/$ over and above its backing value of 0.30 oz/$.

This is where short sellers pounce. They could borrow 10 dollars and sell them for 10 oz. of silver, as in figure 4. As they borrow dollars, the short sellers issue dollar-denominated IOUs that promise to repay $10 worth of assets (ignoring interest). These IOUs can either be used as money directly, or they can be traded for a bank's IOU, which could then be used as money. The proliferation of these IOUs will, on textbook principles, reduce the demand for the Fed’s paper currency, causing it to fall in value, let's say to 0.9 oz/$. Now the short sellers can repay their $10 loan with only 9 oz. of their silver, earning an arbitrage profit of 1 oz. (Note that they don't repay their loan with currency, since buying currency with silver would drive the dollar back up.). The short sellers profited from the inflation that they caused. As the short selling continues, the dollar will continue to fall until it reaches its backing value of 0.3 oz/$, at which point short selling is no longer profitable. (Reality check: Currency traders don't usually deal in silver. A more realistic scenario would have traders borrowing dollars and selling them for British bonds (denominated in pounds). This would reduce the monetary demand for dollars and the dollar would lose value, at which point the traders would swap their British bonds for depreciated US bonds, which they would use to repay their dollar loans.)

So here’s the problem with textbook monetary theory: If you think that money's value is determined by money supply and money demand, and that money trades at a premium over its backing value, then you'd have a hard time explaining how money holds its value in the face of speculative attacks by short sellers. You’d also have to wonder why central banks bother to hold any assets at all. But if you think that asset backing determines money's value, there's nothing to explain. Money's value is governed by its backing, just like stocks, bonds, and every other financial security, and short selling will not affect its value.

Sunday, December 7, 2014

On a recent trip to Ottawa, I stopped by the Bank of Canada. The door was locked and the building empty. Odd, I thought, why would the Bank be closed in the middle of a business day? A security guard strolled up to me and told me that the entire staff packed up back in 2010 and left the country. He hadn't seen them since. Bemused I walked back to my hotel wondering how it was that with no one guiding monetary policy, the loonie hadn't run into either hyperinflation or a deflationary spiral.

Exactly 175 months passed between February 1996, when the Bank of Canada began to target the overnight rate, and September 2010, the date of the Bank's last rate change. Some 63 of those months bore witness to an interest rate change by the Bank, or 36% of all months, so that on average, the Governor dutifully flipped the interest rate switch up or down about four times a year. Those were busy years.

Since September 2010 the Governor's steady four-switches-a-year pace has come to a dead halt. Interest rates have stayed locked at 1% for 51 straight months, more than four years, with nary a deviation. I enclose proof in the form of a chart below. Not only has the Bank of Canada been silent on rates, it hasn't engaged in any of the other flashy central bank maneuvers like quantitative easing or forward guidance. In the history of central banking, has any bank issuing fiat money (ie. not operating under a peg) been inactive for so long?

Worthwhile Canadian chart: The Bank of Canada overnight rate target

Now the Bank of Canada will of course insist that you not worry about the lack of activity, its staff is still toiling away every day formulating monetary policy. But maybe the security guard was right. How do we know they haven't all been on an extended four-year vacation, hanging out in Hawaii or Florida? Who could blame them? Ottawa is awfully cold in the winter! With no one left at the Bank to flip the interest rate switch, that's why it remains frozen in time at 1%.

In theory, the result should be disastrous. With no one manning the interest rate lever, the price level should have either accelerated up into hyperinflation or downwards into a deflationary spiral. Why these two extreme results?

Economists speak of a "natural rate of interest". Think of it as the economy-wide rate of return on generic capital. The governor's job is to keep the Bank's interest rate, or the rate-of-return on central bank liabilities, even with the rate-of-return on capital. If the rate of return on central bank liabilities is kept too far below the rate on capital, everyone will want to sell the former and buy the latter. Prices of capital will have to rise ie. the purchasing power of money will fall. This rise will not close the rate-of-return differential between central bank money and capital. With the incentives to shift from money to capital perpetually remaining in effect, hyperinflation will be the result. Things work in reverse when the governor keeps the rate-of-return on central bank liabilities above the rate-of-return on capital. Everyone will try to sell low-yielding capital in order to own high-yielding money, the economy descending into crippling deflation.

In theory, there is no natural escape from these processes. The Bank needs to intervene and throw the interest rate lever hard in the opposite direction in order to pull the price level out of its hyperinflationary ascent or deflationary descent.

By the way, if this is all a bit boring, you can get a good feel for things by playing the San Francisco Fed's So you want to be in charge of monetary policy... game for a while. When you play, try keeping the interest rate unchanged through the course a game—you'll set off either a deflationary spiral or hyperinflation. Be careful, this game can get a bit addicting.

The upshot of all this is that with the Bank of Canada policy team on holiday and the policy rate stuck at 1%, any rise (or fall) in the Canadian natural interest rate is not being offset by an appropriate shift in the policy rate. Prices should be trending sharply either higher or lower.

However, a glance at core CPI shows that Canadian inflation has been relatively benign. Canada has somehow muddled through four years with no one behind the monetary rudder. How unlikely is that? Imagine Han Solo falling asleep just prior to entering an asteroid field only to wake up eight hours later to discover he'd somehow brought the ship through unscathed. We already know that the possibility of successfully navigating an asteroid field is approximately three thousand seven hundred and twenty to one—and that's with Han awake. If he's asleep, the odds are even lower. By pure fluke, each asteroid's trajectory would have to avoid a sleeping Han Solo's flight path in order for the Millennium Falcon to get through.

Success seems just as unlikely for the Bank of Canada. For us to have gotten this far with no one behind the wheel, the return on capital must not have changed at all over the last four years, the flat 1% interest rate thus being the appropriate policy. Either that or the return on capital zigged only to zag by the precise amount necessary to cancel out the zig's effect on the price level. However, I find it unlikely that the economy's natural rate of interest would stay unchanged for so long, or that its zig zagging was so fortuitous as to preclude a change in rates.

Alternatively, it could be that Canadians assume that the Bank is being vigilant despite the fact that the entire staff has skipped town. Even if a difference between the rate of return on capital and a rate of return on money arises thanks to normal fluctuations in natural rate of interest, Canadians might not take the obvious trade (buy higher yielding capital, sell low-yield money) because they think that the Bank will react, as it usually does, in the next period by increasing the rate of return on money. And with no one taking the trade, inflation never occurs. But is it safe to assume that people are willing to leave that much money on the table?

Another possibility is that the traditional way of thinking about monetary policy needs updating. I considered this possibility here. In short, when the return on Bank of Canada liabilities lags the return on capital, rather than a perpetual acceleration developing the price level stabilizes after a quick jump. This sort of effect could arise from central bank liabilities having some sort of fundamental value. Once the purchasing power of these liabilities falls low enough, their fundamental value kicks in, closing the rate-of-return differential between capital and money and preventing a hyperinflation from developing. So even with no one manning the Bank of Canada interest rate lever, the fundamental value of Bank of Canada liabilities provides an anchor of sorts, explaining why prices have been stable over the last few years.

I may as well come clean about the Bank of Canada. They haven't all gone to Hawaii. The real reason its HQ on Wellington Street was shut the day I visited is that it's being renovated. Rest assured the whole crew is hard at work at a temporary spot elsewhere. But does it make a difference? The monetary policy staff may just as well have gone to Hawaii in 2010. With the interest rate lever neglected and rates frozen at 1%, the evidence shows that prices would not have been sent off the rails, despite the fact that returns on capital surely jumped around quite a bit. It's all a bit odd to me.